By Lance Roberts, CEO, StreetTalk Advisors

For the second time this year the market has broken the neckline of a classical “head and shoulders” pattern. For you non-technical investors this is simply a pattern of price movement that has been indicative of market topping patterns in the past. In fact, outside of the two times this year, the last time we witnessed a clearly defined “head and shoulders” pattern was at the peak of the market in 2008 just before the major crisis hit.

Back in April we first began to recommend overweighting cash and fixed income relative to equities due to the fact that the Quantitative Easing program by the Fed was coming to an end and the lack of stimulus was going to act like a vacuum on the markets. This was a highly unpopular position at the time, especially with the media, but has saved us lots of grief over the summer.

After the initial break of the “neckline” in early August during the midst of the “debt ceiling debacle” the market plunged to 1120 on the S&P 500 index. The market then remained range bound between the lows of 1120 and highs 1220-1230. After the initial plunge we began to repeatedly make calls in our weekly newsletter to sell into rallies due to the overriding weakness in the domestic and international economies. Furthermore, when trends are negative in the market the primary trading rule becomes “selling rallies” rather than “buying dips”. Each attempt at a rally in the markets failed at critical levels of resistance but repeatedly found support at 1120…until today.

The break of the “neckline” today leaves the market in a very tenuous position flirting with the August intraday lows of 1103 on the index. In our opinion this level most likely will not hold and we could well see the markets decline to the next major psychological level of 1000 on the index. This will be consistent with both the retracement of the initial selloff and the break of “neckline” support which should lead to a decline of the same proportion as the original decline. This will also be consistent with traditional bear market declines of 30% from peak to trough.

With the markets now negative for 5 months in a row a sharp decline to flush out investors could well set a short term bottom in the market. However, as we showed in our post on Friday, after 5 or 6 months (depending on how October ends) the markets have always rallied for 3 to 6 months before declining to new lows before finding THE longer term investment opportunity.

The point here is that many investors are now trapped in the market and are hoping for a rally so they can get out. This is why the next rally that we likely see will be into the the end of the year. This will most likely be a “suckers rally” as it will suck investors in as the media bleets about the end of the bear market. Unfortunately, that will be the set up for the decline to the longer lasting bottom. This was very much the same pattern that we saw play out at the end of 2008 as the rally abruptly ended and the markets declined 22% from January to the final low on March 9th.

Caution is highly advised. Having a hefty hoard of cash will provide the ability to take advantage of the next buying opportunity whether it comes sometime this month or next year. There are many threads of this finely woven economic fabric that are now unraveling. As such it will pay not only to be patient but “fashionably late” to the next buying opportunity to make sure it isn’t a “suckers rally”.


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.
Lance Roberts

Lance Roberts

Lance Roberts is the CEO of STA Wealth Managment. The mission of STA Wealth Managment is simple - lead our clients to financial success by actively managing their assets while limiting risk to capture returns. Through the utilization of economic and technical analysis, historical research, and risk controls, we build portfolios which will create long-term investment results.

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  1. Arghhh…there’s a lot of wrong information in this post….and other casual analysis.

  2. S&P at 1000 is also my favourite target for this month. But to me the chart looks really too terrific that S&P could halt at 1000. However I dont see the news that could drive the market below 1000 in the next 2 month. I dont expect Greece to default this month.

    Other news could be:
    -global economic slowdown (Shanghai Composite and Bovespa are continouosly falling)

    -a major US-bank needs fresh money

    Well, my position is 18% long stocks, 32% short S&P500 together with Euro (since the last FOMC-Announcement) and 50% cash. I am looking for a good opportunity to sell my short position, before a year-end-rally starts, which will IMHO trap the bulls. Because of the global slowdown my favourite scenario sees a market bottom not before early 2012. However Mr. Bernanke could start something already this year.

    If no serios market crash happens (S&P 700-800), I plan to buy this year only a few well-capitalized high dividend yield stocks with stable earnings, which trade close to the lows of the past decade.

  3. take the third highest peak, and connect it to the 2nd lowest trough. draw a line perpendicular to that. now connect the 2nd highest peak to the 3rd lowest trough and draw a line perpendicular to that. where these lines intersect is an important turning point. Then you divide that by the golden ratio. BUT this is only true if there is a clear fibonacci retracement to 1987. If not, then pull out dice. If you roll a number 2 or lower, then yes, I agree.

  4. Full Dow Theory Sell. It is a Bear! Model says 80% odds -24% or more will be seen.

  5. So how is the second head and shoulders pattern a topping pattern? If such a thing as a head and shoulders continuation pattern existed that would be it. But it doesn’t exist.

    If anything it is a consolidation before a follow through move.

  6. I just spent an 1.5 hours writing and was maybe half way done correcting the discrepencies and going back to read his posts….I was maybe half way done.

    Some things I can’t control…his numbers are loose and are not confirmed by historical FACT.

    1. Bear markets decline median is 36.06% over 412 trading days. First Rally median is 12.04% over 29 days….
    2. There will be two points one around 966 by Q1 2012 and the second Q1 2013…this is historicaly fact of all Cyclical Bear Markets since the first one 6/17/1901 data sample we use.

    Theres alot alot more but..I am not going long around 950-1000. I am renting this rally until I see a number around 850. You should seee two lows one over the next couple months and another later.

    These are how they have always worked…my impression or thinking is one thing but the data samples are facts to use. Where is he getting his information?

    This market is fractured…there is not enough of a correlation to 2008. At best we saw a 93% correlation to 1966 in September that broke down big. What happens given the fractured state is any ones guess 2-3 months out. The correlation to 2008 was 65% a couple days ago. Theres other stuff…but I should get to work.

  7. Two things. First, head and shoulders targets are legitimate only when its a trend reversal. Second stage head and shoulders and dubious at best.
    Second, the head and shoulders pattern depends on symmetry. This is neither a double-head, single shoulders type, nor a two double shoulders, single head type. It’s instead a shoulder-head-shoulder/head-shoulder type, which makes it a bit of a non-event. It would have been significant had the first shoulder popped.
    That’s not to say a further decline is ruled out. The first head and shoulders has serious implications. It’s more likely we see another test of that neckline before we head further south. However, this one, in itself was not a classic head and shoulder and a phase II is less likely to be particularly strong.